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Amazon: Another Dell In the Making?

Both computing stocks once sported sky-high price/earnings multiples, and both have seen them come way down. But of course that’s where the similarities end.

While Apple’s valuation came down by virtue of soaring earnings, Dell’s took the more common route of a declining share price. Now Apple is the most valuable company on Earth, while Dell is just another leveraged buyout.

What made the expensive Apple of a decade ago so much the better bet than Dell?

Well, Steve Jobs for one. Also, revolutionary products. But none of those advantages would have much helped shareholders without another, underappreciated edge. In 2003, when its trailing price/earnings ratio stood well above 100, Apple had all of $6.2 billion in annual revenue and roughly 3% of the U.S. PC market. Meanwhile, Dell had the ostensibly cheaper stock with a trailing p/e of about 35, $35 billion in annual revenue and a market share above 30%, tops among domestic PC makers. In other words, it had a much shorter runway than Apple.

Now look at those numbers again and guess where Amazon fits in today. This is a company with $61 billion in annual revenue, accounting for more than 15% of U.S. online sales. That’s basically your vintage 2003 Dell. The one way in which Amazon is more like the 2003 Apple is in the lofty multiple its shares fetch, at some 180 times this year’s projected earnings. So this is already a jumbo jet attempting to take off from an aircraft carrier. The chances of this ending well for passengers are low.

That’s far from the consensus at the moment. Amazon shares, triple-digit p/e and all, are up 42% in the last year despite the recent profit-taking. Meanwhile, Apple’s stock is right back where it was a year ago after giving up spectacular gains in equally spectacular fashion.

And because we’re all about instant gratification these days, we tend to tailor our theories to the most recent data point. So Apple shares got killed last month after its $13.1 billion quarterly profit was found wanting, while Amazon’s bounced after it earned all of $97 million. This was explained away with arguments about Amazon’s bright future and claims that Apple must be nearly at the end of its rope.

To back up those theories, a lot of really smart people started citing a November blog post by Eugene Wei, a former Amazon executive. Wei is a brilliant business analyst and his post sheds much useful light on Amazon’s history of operational brilliance and the advantages of its cutthroat pricing strategy.

But what people really seem to have dug is his argument that “an incumbent with high margins, especially in technology, is like a deer that wears a bull’s-eye on its flank.” Presto: there’s your explanation for the slump in Apple’s share price.

Well, yes: high-margin businesses are competition magnets, just like vaults full of cash must be guarded from looters. In contrast, if there’s nothing in your house worth stealing, you’re free to leave the front door wide open and try to loot someone else’s bank vault, I suppose. As a shareholder, however, give me the well-stuffed vault over the talented and hungry looter.

Will Amazon continue disrupting bricks-and-mortar merchants? Absolutely. Though it’s already the dominant e-tailer, online sales still account for barely 5% of the U.S. total, and are still growing at least three times faster. So Amazon’s revenue, currently up 23% year-over-year, may continue expanding nicely for a while.

But the runway will continue to shorten. The neighborhood booksellers are now largely gone, and the depleted competition in electronics may soon follow them into oblivion. Those low-hanging fruit have either already been picked or will be soon. To keep up the growth pace, Amazon will have to keep finding new markets to squeeze, be they in content streaming or electronic payments.

And let’s assume it will find them and masterfully squeeze them, applying its current low-margin strategy. Amazon would then become an even larger company, but still not a particularly profitable one.

Say it quintuples its most recent profit one day soon. That would match the $492 million earned in the most recent quarter by hard-drive maker Seagate Technology (Nasdaq: STX). Except that Seagate is valued at $12 billion, not $121 billion like Amazon.

So the only acceptable long-term outcome for Amazon shareholders is not merely the conquest of new markets but their ruthless exploitation to finally deliver all the profits the company has been deferring. At some point, either the negligible profit margins must soar or the share price must drop. But does Amazon even know how to raise margins, and could it do so if it tried? I think not.

For all the loyalty Amazon has earned from satisfied customers, the barriers to entry into online sales are modest. Thousands of retailers successfully ship products to customers’ doorstep. Scores of retailers have warehouses all over the country. None of this is exactly rocket science any longer.

So all Amazon needs to do to justify its sky-high valuation is to keep finding new markets, squeeze out competitors and then successfully raise prices like it’s never tried to do, and preferably without provoking renewed competition. That seems like a dubious proposition.

There have been plenty of high-multiple stocks that have worked out, but none that I can think of that started with a earnings yield of less than 1% and a valuation above $100 billion. Maybe Amazon will be the first. More likely, it will succumb to the laws of gravity and large numbers. And when it does, the price paid by the shareholders will be brutal.

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While I agree with your sentiment, nothing you have said has anything to do with the Law of Large Numbers, which is a theorem in probability that says that the average value of an experiment repeated a large number of times will converge to its expected value.

Thanks for setting me straight on that. I wonder if there’s a name for the difficulty of growing from a large base. If not, perhaps the time has come to come up with one. The Ballmer Trap? Or maybe just the American Problem?

Thanks very much, Joel. From the company’s standpoint things are working out beautifully; it’s really the shareholders who are assuming all the risk. For Amazon, they need to plan for the day when the investors will start losing patience. Amazon needs to find markets with decent barriers to entry that leverage its bulk and reach. Electronic payments is one, I would think. But the real nobrainer is using their overvalued stock to buy up businesses that could bulk up earnings.

“Thousands of retailers successfully ship products to customers’ doorstep. Scores of retailers have warehouses all over the country.” Isn’t Amazon eating their lunch?

“None of this is exactly rocket science any longer.” Not rocket science, but none the less hard. Retailing is based on a strong brand and terrific execution. Eddie Lampert is the chief non-rocket scientist